Market Whiplash Underscores the Plight of the Federal Reserve
The combination of high U.S. inflation and Russia’s invasion of Ukraine has discombobulated U.S. markets. From Friday to Monday, traders effectively reduced the number of expected rate increases by the Federal Reserve to six from seven by next February, even though, by most accounts, the inflation outlook has only worsened.
The Fed has no good options, and the market is reflecting the indecision that central bankers surely must feel. Europe’s biggest ground conflict since World War II has sent energy prices soaring and shaken financial assets, stirring fears of stagflation that the U.S. hasn’t experienced since the 1970s. There are no great policy remedies for stagflation in normal times, and central bankers have few tools at their disposal with interest rates already near zero. Predicting what they’ll do is a job for mind readers, not traders.
The market isn’t blind to the price pressures across the economy. Breakeven rates on five-year Treasury notes, a measure of market expectations for inflation in the period, are actually increasing and drawing near the highest level in decades. One interpretation is that the market thinks the central bank will simply have to accept inflation running above its long-run target of 2%. Nothing about that scenario is positive, but the Fed may come to see it as the better of two bad choices. The alternative — crushing growth to try to rein in prices, and probably bringing down the stock market in the process — just isn’t palatable.
Another reading of the market is that energy-fueled inflation simply isn’t worth fighting — at least not by the Fed. According to Bloomberg Intelligence strategist Mike McGlone, Brent crude oil prices around $100 a barrel aren’t likely to persist for long and could be set for a big downturn.